Market Failure

Imperfect competitionImperfect competition

Restrict output in order to push Restrict output in order to push up prices and maximize profits up prices and maximize profits (i.e. monopoly & other imperfect (i.e. monopoly & other imperfect markets)markets)

Imperfect market will fail to Imperfect market will fail to equate MSC and MSBequate MSC and MSB

Government may try to reduce this Government may try to reduce this market failure by interveningmarket failure by intervening

Perfect competition (pg Perfect competition (pg 25)25)

Market is perfectly competitive Market is perfectly competitive if there are large number of if there are large number of firms producing identical firms producing identical products facing identical products facing identical production costs and in which production costs and in which there are no barriers to entry or there are no barriers to entry or exit.exit.

Examples: agricultural Examples: agricultural commodities (wheat, coffee, etc.)commodities (wheat, coffee, etc.)

Government interventionGovernment intervention

They may use legal measures to They may use legal measures to make markets more competitive. make markets more competitive. They may pass laws that do not They may pass laws that do not permit mergers or takeovers that permit mergers or takeovers that give an individual firm more than give an individual firm more than a certain percentage of the a certain percentage of the market.market.

They may set up regulatory bodies They may set up regulatory bodies to investigate markets where it is to investigate markets where it is felt that monopoly power is being felt that monopoly power is being used against the public interest.used against the public interest.

Market Failures:Monopoly PowerMarket Failures:Monopoly Power

• The demand curve under monopoly– production at less than the social optimum

• The demand curve under monopoly– production at less than the social optimum

MC1

Q1

MC

MRAR

A monopolist producing less than the social optimum

O

P1

£

Monopoly output

Q

O

P1

MC1

MC = MSC

Q1

MRAR = MSB

Q2

P2 = MSB

= MSC

£

QMonopoly output Perfectly competitive output

A monopolist producing less than the social optimum

Market Failures:Monopoly PowerMarket Failures:Monopoly Power

• The demand curve under monopoly– production at less than the social optimum

• Deadweight loss under monopoly– consumer and producer surplus

• consumer surplus

• The demand curve under monopoly– production at less than the social optimum

• Deadweight loss under monopoly– consumer and producer surplus

• consumer surplus

Market Failures:Monopoly PowerMarket Failures:Monopoly Power

• The demand curve under monopoly– production at less than the social optimum

• Deadweight loss under monopoly– consumer and producer surplus

• consumer surplus

• producer surplus

• The demand curve under monopoly– production at less than the social optimum

• Deadweight loss under monopoly– consumer and producer surplus

• consumer surplus

• producer surplus

Market Failures:Monopoly PowerMarket Failures:Monopoly Power

• The demand curve under monopoly– production at less than the social optimum

• Deadweight loss under monopoly– consumer and producer surplus

• consumer surplus

• producer surplus

• total surplus

• The demand curve under monopoly– production at less than the social optimum

• Deadweight loss under monopoly– consumer and producer surplus

• consumer surplus

• producer surplus

• total surplus

O

£

Q

Ppc

Qpc

AR = D

Consumersurplus

Producersurplus

Deadweight loss under monopolyMC

(= S under perfect competition)

(a) Industry equilibrium under perfect competition(a) Industry equilibrium under perfect competition(a) Industry equilibrium under perfect competition(a) Industry equilibrium under perfect competition

a

Market Failures:Monopoly PowerMarket Failures:Monopoly Power

• The demand curve under monopoly– production at less than the social optimum

• Deadweight loss under monopoly– consumer and producer surplus

• consumer surplus

• producer surplus

• total surplus

– the effect of monopoly on total surplus

• The demand curve under monopoly– production at less than the social optimum

• Deadweight loss under monopoly– consumer and producer surplus

• consumer surplus

• producer surplus

• total surplus

– the effect of monopoly on total surplus

MRO

£

Q

Ppc

Qpc

AR = D

a

Qpc

Pm

bConsumer

surplus

Producersurplus

Deadweightwelfare loss

MC(= S under perfect competition)

(b) Industry equilibrium under monopoly(b) Industry equilibrium under monopoly(b) Industry equilibrium under monopoly(b) Industry equilibrium under monopoly

Deadweight loss under monopoly

O

£

Q

Ppc

Qpc

AR = D

Consumersurplus

Producersurplus

MC(= S under perfect competition)

(a) Industry equilibrium under perfect competition(a) Industry equilibrium under perfect competition(a) Industry equilibrium under perfect competition(a) Industry equilibrium under perfect competition

a

Perfectcompetition

Deadweight loss under monopoly

MRO

£

Q

Ppc

Qpc

AR = D

a

Qpc

Pm

bConsumer

surplus

Producersurplus

Deadweightwelfare loss

MC(= S under perfect competition)

(b) Industry equilibrium under monopoly(b) Industry equilibrium under monopoly(b) Industry equilibrium under monopoly(b) Industry equilibrium under monopoly

Monopoly

Deadweight loss under monopoly

Market Failures:Monopoly PowerMarket Failures:Monopoly Power

• The demand curve under monopoly– production at less than the social optimum

• Deadweight loss under monopoly– consumer and producer surplus

• consumer surplus• producer surplus• total surplus

– the effect of monopoly on total surplus

• Other problems with monopoly• Possible advantages from monopoly

• The demand curve under monopoly– production at less than the social optimum

• Deadweight loss under monopoly– consumer and producer surplus

• consumer surplus• producer surplus• total surplus

– the effect of monopoly on total surplus

• Other problems with monopoly• Possible advantages from monopoly

Market Failures:Monopoly PowerMarket Failures:Monopoly Power

• The demand curve under monopoly– production at less than the social optimum

• Deadweight loss under monopoly– consumer and producer surplus

• consumer surplus• producer surplus• total surplus

– the effect of monopoly on total surplus

• Other problems with monopoly• Possible advantages from monopoly

• The demand curve under monopoly– production at less than the social optimum

• Deadweight loss under monopoly– consumer and producer surplus

• consumer surplus• producer surplus• total surplus

– the effect of monopoly on total surplus

• Other problems with monopoly• Possible advantages from monopoly

Other Market FailuresOther Market Failures

• Ignorance and uncertainty• Immobility of factors and time lags• Protecting people's interests

– dependants– the principal–agent problem

• the problem of asymmetric information• the need for monitoring

– poor economic decision making by people• merit goods

• Macroeconomic goals• Economists and policy advice

• Ignorance and uncertainty• Immobility of factors and time lags• Protecting people's interests

– dependants– the principal–agent problem

• the problem of asymmetric information• the need for monitoring

– poor economic decision making by people• merit goods

• Macroeconomic goals• Economists and policy advice

Government Intervention:Taxes and Subsidies

Government Intervention:Taxes and Subsidies

• The use of taxes and subsidies to correct externalities– the optimum size of a tax

• The use of taxes and subsidies to correct externalities– the optimum size of a tax

Q1O

MC = S

DP

Co

sts

and

be

nef

its

Quantity

Using taxes to correct a market distortion (“first-best” world)

O

MC = S

DP

MSC

Co

sts

and

be

nef

its

Quantity

External cost

Q1Q2

Social optimum

Using taxes to correct a market distortion (“first-best” world)

Q2

MC

Q1O

DP

Co

sts

and

be

nef

its

Quantity

Optimum tax = MSC – MC

MC = SMSC

Using taxes to correct a market distortion (“first-best” world)

Government Intervention:Taxes and Subsidies

Government Intervention:Taxes and Subsidies

• The use of taxes and subsidies to correct externalities– the optimum size of a tax

– the optimum size of a subsidy

• The use of taxes and subsidies to correct externalities– the optimum size of a tax

– the optimum size of a subsidy

O

DP

MC = S

Q1

Co

sts

and

be

nef

its

Quantity

Using subsidies to correct a market distortion (“first-best” world)

O

MSC

DP

Q1

External benefit

Co

sts

and

be

nef

its

Quantity

MC = S

Q2Social optimum

Using subsidies to correct a market distortion (“first-best” world)

MC

O

P

Q2Q1

Co

sts

and

be

nef

its

Quantity

Optimum subsidy

= MC – MSC

MSCMC = S

D

Using subsidies to correct a market distortion (“first-best” world)

Government Intervention:Taxes and Subsidies

Government Intervention:Taxes and Subsidies

• The use of taxes and subsidies to correct for monopoly– use of lump-sum taxes

• Advantages of taxes and subsidies

• Disadvantages of taxes and subsidies– infeasible to use different tax and subsidy

rates

– lack of knowledge

• The use of taxes and subsidies to correct for monopoly– use of lump-sum taxes

• Advantages of taxes and subsidies

• Disadvantages of taxes and subsidies– infeasible to use different tax and subsidy

rates

– lack of knowledge

Government Intervention:Laws and Regulation

Government Intervention:Laws and Regulation

• The use of laws and regulation

• Advantages of legal restrictions

– simple to understand

– safer when size of problem is potentially great

– quick to implement

– a good way of dealing with imperfect information

• Disadvantages of legal restrictions

– a 'blunt weapon'

• The use of laws and regulation

• Advantages of legal restrictions

– simple to understand

– safer when size of problem is potentially great

– quick to implement

– a good way of dealing with imperfect information

• Disadvantages of legal restrictions

– a 'blunt weapon'

Government Intervention:Laws and Regulation

Government Intervention:Laws and Regulation

• Types of regulation

• The system of regulation in the UK

– UK regulatory bodies

– price-cap regulation• the RPI–X formula

• Advantages of the UK system

– discretionary

– flexible

– incentive for firms to reduce costs

• Disadvantages of the UK system

• Types of regulation

• The system of regulation in the UK

– UK regulatory bodies

– price-cap regulation• the RPI–X formula

• Advantages of the UK system

– discretionary

– flexible

– incentive for firms to reduce costs

• Disadvantages of the UK system

Other Forms ofGovernment Intervention

Other Forms ofGovernment Intervention

• Changes in property rights– the problem of limited property rights

– extending property rights

– limitations of this solution• impractical in many situations

• problems of litigation

• questions of equity

• Provision of information– consumer information

– information on jobs

– information to firms

• Changes in property rights– the problem of limited property rights

– extending property rights

– limitations of this solution• impractical in many situations

• problems of litigation

• questions of equity

• Provision of information– consumer information

– information on jobs

– information to firms

Other Forms ofGovernment Intervention

Other Forms ofGovernment Intervention

• Direct provision of goods and services– the provision of public goods

– the need to evaluate costs and benefits of publicly provided goods

– the provision of other goods and services by the government• social justice

• large positive externalities

• dependants

• ignorance

• Direct provision of goods and services– the provision of public goods

– the need to evaluate costs and benefits of publicly provided goods

– the provision of other goods and services by the government• social justice

• large positive externalities

• dependants

• ignorance

More or Less Intervention?More or Less Intervention?

• Drawbacks of government intervention– shortages and surpluses

– poor information

– bureaucracy and inefficiency

– lack of market incentives

– shifts in government policy

– voters' ignorance

– unrepresentative government

– lack of freedom for the individual

• Drawbacks of government intervention– shortages and surpluses

– poor information

– bureaucracy and inefficiency

– lack of market incentives

– shifts in government policy

– voters' ignorance

– unrepresentative government

– lack of freedom for the individual

More or Less Intervention?More or Less Intervention?

• Advantages of the free market– automatic adjustments

– dynamic advantages of capitalism

– possibly high degree of competition even under monopoly/oligopoly

– Judging the arguments

• Should there be more or less intervention in the market?– important to consider both costs and benefits of

intervention

– moral issues

– problem of predicting effects of intervention

• Advantages of the free market– automatic adjustments

– dynamic advantages of capitalism

– possibly high degree of competition even under monopoly/oligopoly

– Judging the arguments

• Should there be more or less intervention in the market?– important to consider both costs and benefits of

intervention

– moral issues

– problem of predicting effects of intervention